It’s that time of year again: while some may think we might be referring to the Masters’ Golf Tournament (maybe our favorite sporting event, coming up in a few weeks), we’re actually referring to something much less pleasurable: income tax filing. This year, the deadline is April 18th and for many people it’s annoying at best and downright terrifying at worst.
Without proactive tax planning, most people are staring at either a Turbo Tax screen or their accountants’ mystifying tax documents and ultimately just want to know one thing: “Will we have to write a check to Uncle Sam or will I be getting some cash back?”
It doesn’t have to be this way. In fact, as integrated financial advisors we think it’s prudent to always be cognizant of federal and state income taxes, typically our clients’ largest expenditure each year. (DISCLAIMER: We are not CPAs, nor enrolled agents so this should not be construed as formal tax advice as all families’ tax situations are different. You should consult your CPA or enrolled agent for specific tax advice.)
Even though we are not CPAs nor enrolled agents we still partner closely with CPAs to ensure our clients are always compliant with tax laws and regulations. This means our CPA-partners fill out tax forms, research the applicable issues, sign the returns and work with tax authorities, if necessary.
As financial advisors, nobody is more involved in our clients’ financial lives. For this reason, we believe staying sharp on taxes throughout the year is essential, and potentially profitable, for our clients. Realizing this, we always try to employ what we think might be an underappreciated approach to tax planning: the “front page” deduction.
“Front page” deductions are those tax deductions that actually lower AGI (adjusted gross income) on the “front page” of the federal tax return (Form 1040). These tend to be more “valuable” because they can positively impact other parts of the tax return, much more so than the typical, and similar, “Schedule A” deductions (a.k.a. itemized deductions). Why is this? In general, because other Schedule A deductions use the AGI number as the basis to determine how much of these expenses can be deductible.
For example, if you have lower AGI you could see a larger tax deduction for:
- out-of-pocket medical expenses
- miscellaneous deductions (such as financial planning and tax preparation fees)
- casualty losses and others
In addition, you could also lower the amount of social security income that would be taxable (assuming you are currently taking social security).
But the trick is to lower the AGI in order to benefit more from those deductions. This can be accomplished by employing the “front page” deductions. For instance, instead of contributing to a charity and deducting it on Schedule A, maybe our retired clients should use a Qualified Charitable Deduction as part of their IRA required minimum distribution. Also, as financial advisors we keep a sharp eye on those investment accounts and try to offset capital gains with capital losses during the year so as to either lower the capital gain income (on the front page) or maybe even maximize the $3,000 annual allowable capital loss. Other examples include contributing to Health Savings Accounts and ensuring all expenses for a small business are fully (and legally) recognized as offsets to income.
This may all sound too nerdy for some but if we illustrate with an example, you may sit up and take notice at the material tax savings which could be realized by knowing how to employ these strategies.
Let’s say we have a retired married couple with the following gross income totaling about $118,000
- $8,000 of interest & dividends
- $5,000 of capital gains
- $50,000 of IRA distributions
- $40,000 of Social Security income ($34,000 taxable)
- $15,000 of consulting work income
And let’s say they have the following expenses, some of which are deductible:
- $10,000 of out-of-pocket medical expenses ($300 is deductible because their income is so high)
- $8,000 of real estate taxes
- $10,000 of charitable contributions
- $7,500 of tax and financial planning fees
Overall, we estimate this couple would owe about $10,372 in federal income tax or about 12.8% of taxable income – not too shabby.
But, what if we made the following changes (with all other deductions remaining the same) with “front page” deductions to lower our AGI and the tax burden?
- Make a QCD (qualified charitable distribution) to donate the $10,000 directly to charity from our RMD instead of donating from our checking account and deducting on Schedule A
- Maximize the contribution to the HSA (if qualified) and pay most medical expenses with these funds
- Incorporate a tax-loss harvesting strategy in taxable investment accounts to deduct the maximum $3,000 capital loss each year
- Document and deduct $5,000 of expenses related to the consulting work
By making these changes, we have lowered our taxable income from $80,640 to only $50,246 which means our tax bill is now only about $5,841 – an annual savings of over $4,500!
In our minds, this illustrates the difference between financial planning and having “an investment guy”. Sure, it may not be the latest & greatest stock tip (which usually crashes & burns anyway) but tax savings is real cash flow. In addition, these savings can compound year after year adding materially to families’ net worth.
The point is this: taxes can be confusing, boring, scary and annoying all at once. But knowing how the 1040 tax return works can add substantial value when combined with prudent investment advice. This is why when we meet with our clients on the various financial topics throughout the year, we always have our ears open for how to lower that AGI and potentially lower the tax liability, putting real money back in our clients’ pockets.
Comments? Questions? Feel free to enter them below and we’re happy to address.